As Europe Toils on Debt, U.S. and Japan Watch Nervously

January 26, 2011, 5:23 am Davos 2011

Z ALDERMAN

Andrew Harrer/Bloomberg News The gold-starred European Union flag outside the Davos Congress Center on opening day of the World Economic Forum.

DAVOS, Switzerland — The fiscal crisis in Europe may be only the beginning.
The debt debacle that erupted last year in Greece and Ireland threatens not just Europe’s economic stability. It has also revived longstanding questions about whether the United States and Japan, weighed down by their own debt, are heading for a moment of truth.
For all their differences, the big, rich economies of the world are confronted by stark similarities. Each has a mountain of debt that is proving harder and harder to support, given the way their societies are structured.
Trapped by aging populations, underfunded pensions and social security commitments, their dilemma is in sharp contrast to the current vigor and youth of emerging economies. China and India may have growing pains — but debt is not one of them.
This contrast is on display in Davos, where the annual World Economic Forum has brought together a confident group of representatives from emerging economies and the exceptionally comfortable but increasingly worried members of the Western world’s elite.
“Between debts and pensions, everyone should realize that this can’t go on forever,” said Kenneth S. Rogoff, an economics professor at Harvard University in Massachusetts and a former chief economist of the International Monetary Fund. “‘We’ll be lucky if it can go on another five to 10 more years.”’

Until recently, debt was hardly a dirty word, especially in Western countries that borrowed to finance economic growth. But few of them managed to shrink their debt when times were good, and instead promised richer pensions and welfare benefits.
In the case of the United States, the surpluses built during President Bill Clinton’s tenure turned into huge deficits during the administration of President George W. Bush.
Now, after bailouts in Greece and Ireland, the unthinkable is becoming more probable. As a result, investors are scrutinizing nearly every country with high debt — with potentially bewildering consequences.
“I could envisage them focusing on California debt in one moment, and in the next on another European country,” said Joseph E. Stiglitz, a Nobel laureate in economics.
“So I could see a series of rolling crises for an extended period of time,” he continued, in which investors “try to bring about the adverse results they anticipate.”
While investors’ immediate targets are countries like Portugal that are easy to pick off, they could yet challenge the United States and Japan, as debt levels continue to rise.
This month, two ratings agencies warned that the triple-A rating for the United States could be reviewed in a couple of years if the country’s national debt kept growing.
A downgrade is unlikely to happen as long as the United States economy and the dollar retain their dominance on the global economic stage.
But more people are sounding the alarm as Congress prepares to raise the debt ceiling this spring and politicians lock horns over how to forestall a debt crisis.
At the same time, several states, particularly Illinois, are feared to be on the brink of insolvency, possibly requiring a bailout. The burden has mushroomed so quickly that some policy makers are asking Congress to consider the once-unthinkable possibility of allowing states to file for bankruptcy. That may be the only way, advocates of this approach argue, to alleviate overwhelming debts, including huge pension obligations that are siphoning money from education and other state services.
The risk is that the mere talk of such measures could destabilize investors’ faith in United States municipal bond markets.
As in Europe, the most troubled states are pushing deep spending cuts — and, to some extent, tax increases — to narrow their budget gaps, leading to more layoffs and slowing economies. Although the United States economy is showing signs of a revival two years after the recession ended, and the stock market is roaring back, a downturn among big states could weigh on the recovery, stymieing broader efforts to reduce the national debt and deficit.
At the same time, financial players are watching for any hidden bombs that might explode, like greater losses in state pensions than have been reported, analysts said.
While the United States is no Greece, “these things turn on a dime,” Mr. Rogoff said. “Nothing seems to be happening, then boom, you’re slammed over the head when interest rates rise, debt hits a certain level or something shakes global markets.”
Japan is more of a question mark. The Japanese prime minister, Naoto Kan, has warned that the nation faces a financial crisis of Greek proportions if it does not tackle a debt that is expected to rise to 210 percent of the country’s gross domestic product next year.
The country has struggled to revive its economy for more than a decade, hobbled by deflation and a rapidly aging population. Japanese savers hold nearly all of the debt, making it less vulnerable to the market’s activities. But the concern is that retirees may begin to cash in their bonds, which would make the government look abroad for financing.
“Japan is a debt time bomb that is waiting to explode,” said Paul De Grauwe, a professor of international economics at the Catholic University of Leuven in Belgium.
If global interest rates start to rise, that could affect Japan’s ability to service its debt, “and then Japan will be hit by a debt crisis,” he said. Once the nation heads down that path, “it doesn’t mean much if the debt is held domestically or by foreigners — everyone sells, including the patriots.”
Analysts say that, as with the United States, any reckoning in Japan could still take years or even decades to unfold.
The more immediate concern is how to keep the debt crises in small European countries on the periphery from rocking Europe at its core.
European finance ministers have been working on ways to protect the euro and are focusing on whether to bolster a rescue fund for the Union. But the survival of the euro cannot be taken for granted if policy makers fail to resolve underlying problems.
Some countries are taking steps to avert disaster. Spain, feared to be one of the next countries after Ireland to need a bailout, is casting its net wide for buyers of its bonds, which it is shopping to China, Japan, Qatar and Russia.
These nations have as big a stake in Europe’s economic stability as the West, because the European Union is one of their biggest markets.
To the extent international buyers are shunning their debt, governments are trying to compel domestic institutions to load up on it. Ireland, for instance, has passed legislation to encourage Irish pension funds to hold more Irish government bonds and dump lower yielding, but safer, German bonds.
In the meantime, something that would help all these countries reduce their debt is a revival of economic growth. But one lesson emerging from the European debt crisis is that imposing harsh austerity to mend finances risks feeding a downward economic spiral. Spending cuts are stunting economies, causing governments to borrow more at higher interest rates and piling debt upon debt.
“‘We know from historical experience if debt levels are high and remain high you will pay the price in terms of lower growth,” said Pier Carlo Padoan, chief economist at the Organization for Economic Cooperation and Development, the association of free-market democracies. “All countries face the need, first, to stop debt levels from growing, and second, to start bringing them down.”