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Why the Global Economy Is Tanking

Last Sunday, legislators and the president, convinced that the United States was facing an imminent risk of default and their sound decisions were needed to wrest global well-being from the jaws of collapse, purportedly scrambled to announce a deal on the debt ceiling hours before the Asian markets opened. Instead of cheering the deal, however, global markets thumbed their nose and turned down within hours of the announcement. Indeed, the most striking response to the “successful” conclusion of the United States debt ceiling cacophony on Sunday was the sharp fall in global stock markets the next day. Then, on Thursday, the Dow plunged over 500 points, the biggest single-day loss since December 1, 2008, at the height of the financial crisis. Why the painful downturn?

The failure of markets to rally around the purported good news reflects the far deeper troubles our global economy faces. The chaotic conclusion to the U.S. debt ceiling debate, meanwhile, only makes the future look bleaker, because it signals that U.S. politicians, like their European and Japanese counterparts, may be incapable of responding in a timely fashion to these momentous issues.

The overriding problem that most wealthy nations face is they have promised far more in public sector spending than they are currently willing to pay for in taxes. In the United States, the federal government spends 1.7 times its total revenues, leaving the country with a 9-10 percent 2011 GDP budget deficit, and little route to a solution if, as the Republicans demand, no further revenues are raised. It remains unclear how anyone decided that the federal government must not collect revenues exceeding 18 percent of GDP, irrespective of what happens as the society ages, but influential Republicans are pushing for a constitutional amendment that would set this limit in stone. Even tax reforms that would raise revenues, while lowering distortions, are apparently out of the question.

In Europe, the European Union ignored the profligate spending of the periphery, along with their reckless banks, only to wake up in recent months and call for rapid and deep austerity and change. In Japan, the government continues marching onward with large deficits and a climbing public sector debt to GDP ratio which, properly measured, is now the highest in the world.

None of the current policy stances in the United States, Japan, or Europe is sustainable. The most immediate problems are located in the euro area, where Greece’s upcoming default may ultimately lead to a series of defaults and debt restructurings across the periphery. European leaders are proving incapable of dealing with the issue. It was just 15 months ago that they claimed to have resolved Greece’s problems with a bailout program in May 2010. They have vowed no sovereign defaults would occur on European soil, yet this is exactly what is now underway.

Yet the newly prescribed Greek default will not solve Greece’s problems: It still has too much debt and too large a budget deficit. Nor is it credible that Ireland or Portugal can avoid default under current circumstances. The willingness to let defaults occur is already spurring flight from Italian and Spanish bonds. According to JP Morgan, the Italian treasury only has enough cash on hand to finance itself into September, meaning Europe’s third largest nation, with 1.6 trillion euros of sovereign bonds outstanding, is on the verge of a major financing crisis.

Japan’s problems, on the other hand, are longer term but similarly incontrovertible. Their population is aging rapidly, and the number of workers is now in decline. Instead of planning for the coming demographic challenges, however, the political leadership has run large budget deficits, ramping up their debts just as the tax-paying population begins to fall. If they stay on the current trajectory, a few lonely taxpayers will be responsible for massive debts. The solution to Japan’s problems (advocated both by the IMF and the Bank of Japan, as well as many in Japan’s Ministry of Finance) is harsh but simple: They need to increase the sales tax substantially to close the budget deficit. Despite this, successive Japanese governments have failed to deal with the problem. Instead, they continue to build up debt in an unsustainable manner.

In this context, the debate in the United States seems par for the course. The U.S., unlike Europe but like Japan, does not face imminent collapse. Yet the country’s fiscal issues are daunting. Even if we accept the Congressional Budget Office’s optimistic economic growth forecasts, on our current policy track America’s net debt will increase to 100 percent of GDP by 2020. This is up from just 40 percent of GDP at the end of 2008.

Even these optimistic forecasts were dealt a serious blow last week when the Bureau of Economic Analysis reported that first quarter GDP in the United States grew at a paltry annual rate of 0.4 percent, revised down from the already disappointing level of 1.9 percent. Second quarter growth has been estimated at just 1.3 percent. These figures are well below the 3 percent average annual rates assumed by the CBO in their budget forecasts to 2020. If growth averages 1 percent lower then the estimates, then America’s debt to GDP ratio would likely rise by an additional 14 percentage points by 2020. The impact of such modest changes in growth forecasts swamp the spending cuts that were just agreed to in the culmination of the debt ceiling debate.

Careful politicians who assess risks appropriately would not base today’s budgets on such rosy future outlooks. We know that both households and indebted corporations will likely continue to save and pay down loans rather than spend or invest. Emerging markets will grow faster, but they can increasingly produce sophisticated goods more cheaply at home, so our scope for export growth is limited as well. Responsible fiscal policy requires that we gradually reduce budget deficits and prevent the current risk of a deleterious spike in public debt levels. But talk of “death panels” has scared all politicians from discussing the obvious—health care costs for the United States are not under control (for the private sector as well as for the public sector); within 20 years, it is clear to every observer that this will be a main source of fiscal crisis if nothing is done.

As in Japan and Europe, the American political process has proved incapable of dealing with this issue resolutely. The final agreement announced late Sunday evening offers no credible solutions to control healthcare costs, nor did it face the question of sensible ways to boost revenues. In order to even get a deal, economic projections were based on far more rosy scenarios than most in Washington truly believe are plausible. If one simple decision and relatively small deal take such crisis mongering and brinkmanship, how will America deal with the far more serious decisions to come?

When faced with daunting problems, politicians in industrialized countries are struggling to adapt to their new realities in which their borrowing becomes finite. So far, not one is proving remotely capable of dealing with this task.

Peter Boone is a principal at Salute Capital Management and non-resident senior fellow at the Peterson Institute for International Economics (PIIE). Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at MIT’s Sloan School of Management and Senior Fellow at PIIE.