Andrew Gawith: Debt makes even strong nations vulnerable

The Eurozone crisis of early this month has been contained for now by a mammoth €700 billion ($1.2 trillion) rescue package.

The panic that preceded the package and the size of it tells us a lot about the magnitude of the underlying fiscal adjustment required, especially in southern European countries.

In contrast to the economic woes in Europe, the United States appears to be growing its way out of trouble with mostly good news flowing from the important indicators - unemployment, industrial production, retail sales. Forecasters are picking US growth to come in at about 3 per cent this year.

Over the other side of the Pacific, China is still dabbing the monetary brakes to contain its sizzling economy, while Japan searches for a way to accelerate its economy. Closer to home the Australian economy is in pretty good nick and New Zealand is on the mend.

On the face of it there appears to have been a growing divergence in economic fortunes over the past 18 months, between Europe and the US and even within Asia.

Since the 2007-09 global financial crisis, when most economies found themselves in the same boat, developed economies have pushed and pulled themselves back to growth at different rates. But has world economic growth really become more diversified and therefore resilient to shocks?

The strong rally in world share markets over the past year (the MSCI world index in US dollar terms rose 38 per cent over the year ended April 2010) suggests a positive response to this question - sovereign debt problems in southern European countries were of little obvious concern to the major economies and their recovery stories.

But perhaps the real answer came this month when markets and credit rating agencies recognised the looming debt crisis in Europe and its potential to threaten economic recovery more generally.

That risk was emphasised by how quickly Germany and France came to the party on the rescue package - in contrast to the hand-wringing involved in sealing a deal for Greece - and also the involvement of the US, Britain, and possibly others in ensuring there was a rescue package.

The fact is markets and then governments were spooked by the potential for the eurozone crisis to morph into a global liquidity crisis. That would have annulled the nurturing that had gone into the recoveries in the US, Germany, etc - governments were very motivated to avoid that happening.

So, no; increasingly diversified economic performance has not yet made the global economy less immune to debt problems in tiny countries like Greece.

There are several reasons for this.

Firstly, high levels of debt remain a major threat to sustained growth in virtually all developed economies. Until debt levels have been reduced rather than simply shifted from the private to the public sectors, then recoveries are vulnerable.

There are few developed economies with comfortably low levels of debt - Australia is possibly one. The Greek crisis reminded investors of the dangers of providing credit especially where there is any realistic potential for default.

Secondly, growth in most countries is still drug-induced. That is, there is a very heavy reliance on expansionary monetary and fiscal policy to achieve the results they are achieving.

Unlike Greece and Ireland the US has greater control over these important economic policy levers. But that does not necessarily inoculate the US recovery against a loss of confidence in the value of the debt the US is accumulating in its quest for economic growth.

Thirdly, the global financial crisis was a clear demonstration of just how inter-linked the world financial system has become. A problem in one area can easily affect the whole system no matter how small that problem may seem - Greece is insignificant to the world economy, but it clearly helped expose a wider problem.

A related point is that capital markets are definitely global and powerful. While European politicians criticise the wolf-pack behaviour of capital markets for "hunting down the weakest", savers should be grateful fund managers and credit agencies are now more discerning about the quality of the investments they are willing to make.

Taxpayers may soon wish their politicians were also more careful with how their taxes are managed.

In summary, the fortunes of developed economies remain tightly linked and until debt is slashed across the developed world most economies are vulnerable to debt problems in one country spreading to the rest.

Cutting debt will be painful and while economic growth is a great cure it can be difficult and sometimes expensive.

* Andrew Gawith is a director of Gareth Morgan Investments www.garethmorgan.com