As Greece's Woes Demonstrate, the Fuse Has Been Lit on the Global Debt Bomb

The big story in the international markets so far in the New Year has been the increasing shakiness of a number of countries' government bonds, with Greece right now being the most troubled of all.

Since U.S. investors tend to avoid foreign government bonds, many will dismiss this as an irrelevant development.

That's a mistake. The reality is that the international implications of this bond-market problem are serious for the world's stock markets, as well as for the global economy as a whole.

The fuse has been lit on a global debt bomb. And Greece has quickly become a poster child for the explosion that's all but certain to occur.

From its entry to the European Union in 1981, until the arrival of even weaker Bulgaria and Romania in 2004, Greece was the economic weak sister of the mostly rich countries in the EU. Its original entry was prompted by a wish to reward the country for getting rid of its dictatorship in 1974, while remaining a member of NATO and not succumbing to the blandishments of Russia and the Warsaw Pact (its neighbors were all of Communist persuasion, in one form or another).

For most of the 15 years after its EU entry, Greece was run by Andreas Papandreou, one of the most unreconstructed socialist politicians of that generally free-market period.  As a result, despite having had a head start of 23 years on the Central European countries that entered the EU in 2004, its economy was both more indebted and poorer than most of them.

Greece entered the Eurozone (the nations that use the euro monetary unit) in 2000, but had to fudge its figures to do so. It then violated the terms of the Stability Pact from 2001 to 2006, running excessive budget deficits in each of those years. It satisfied the criteria in 2007, then blew them out altogether by 2009, a year in which its budget deficit equaled 12.7% of gross domestic product (GDP). By the end of that year, Greece's public debt had reached 108% of GDP – lower than that of Italy and Japan, but with no obvious sign that it would soon be brought under control.

It came to a head last month.

Greece's financing needs – $48 billion for 2010, or about 15% of GDP – caused disquiet among investors. Spreads of medium-term Greek debt over comparable German paper widened to nearly 4%.

Since Greece has fiddled its figures and run excessive budget deficits, it is technically ineligible for an EU bailout. German Chancellor Angela Merkel – at least for now – is resisting imposing this additional burden on German and other EU taxpayers. There is a sporting chance of an International Monetary Fund (IMF) bailout – though not for $48 billion. And Greece reasonably would prefer to avoid the rigors of mandatory IMF advice when it can probably squeeze money out of the EU by threatening to destabilize the euro.

In terms of balance-of-payments imbalances, there are European countries in worse trouble than Greece: Latvia springs to mind – but Latvia is not a member of the euro, and has the excuse of the transition from communism. In any case, Latvia's record over the last two decades is one of admirable devotion to free-market principles and a resolve to put its house in order – very different to the panhandling Greece. So a Greek default on its foreign debts is both more likely than a Latvian default and more dangerous for the international markets.

A simple default by Greece would probably not be too damaging, except to Greece's Mediterranean neighbors: Italy, Spain and Portugal (together known as the "PIGS," a very different collective from the fast-growing "BRICs"). However, a default that was accompanied by Greece's forced exit from the euro – on the grounds that it had become hopelessly uncompetitive – would bring the stability of the euro itself into question. That would be hugely damaging to world confidence, since the U.S. dollar, the Japanese yen and the British pound don't look too solid, either.

The other PIGS are not much better off than Greece. Overall, Portugal is probably the best run of this group. But it currently has a budget deficit of 9% of GDP and a current-account deficit of 9% of GDP. Its public debt – at only 75% of GDP – is a bit more tolerable.

Spain has suffered an enormous real estate downturn (but not a complete banking collapse, because the Bank of Spain was far more cautious than the U.S. Federal Reserve in the leverage it allowed local banks during the boom).

However, Spain right now has a poor quality government, a budget deficit of 12% of GDP and 20% unemployment – not a good combination. Italy has the highest debt – at 115% of GDP, but its management is better than it appears, and its budget deficit is only 5% of GDP. So after Greece, Spain – rather than Portugal or Italy – appears to be in the most trouble, even though its public debt is only 60% of GDP.

Mind you, one doesn't have to be among the PIGS to be in danger of default. Britain has a budget deficit of 14% of GDP – and no obvious plan to reduce it. Japan has public debt equal to 200% of GDP, and a budget deficit that is rising.

And, of course, there's always the United States to worry about.

As the global debt bomb builds, it seems increasingly likely that the international bond markets will see a major national default during the next couple of years. The favorites right now would seem to be either a Eurozone member, or perhaps Britain or Japan.

If that happens, we'll see risk premiums widen in the world's bond markets, making money more expensive. Usually, the rich countries end up benefiting from tight money. Not this time, however. Most of those "rich" nations have budget difficulties (Australia and Canada are the exceptions).

When the international debt bomb blows, it will be China and other Asian exporters that will reap the benefits. They have the huge foreign exchange reserves needed to do so. As a result the global balance of power and money will lurch still further in their direction.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps – half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

To find out more about The Permanent Wealth Investor, please just click here.]

News and Related Story Links:

• Money Morning Commentary:
  Obama Deficit Brings Us Closer to the Brink of National Bankruptcy
  
• Money Morning Commentary:
  Which of the "Rich Four" Countries Will Default First?
  
• Fordham.edu:
  The Warsaw Pact
  
• Wikipedia:
  Andreas Papandreou
  
• Merriam-Webster Online:
  Unreconstructed
  
• StabilityPact.org:
  Stability Pact for Eastern Europe
  
• Money Morning News Analysis:
  Credit Trouble for Spain and Greece Spreads Fears of Sovereign Defaults
  
• Wikipedia:
  Balance of Payments
  
• Money Morning News Analysis:
  Will Greece Default on its Debt, and Take the Eurozone Down with It?
  
• Wikipedia:
  Angela Merkel
  
• International Monetary Fund:
  Official Web Site
  
• Money Morning News Category:
  The BRICs
  
• The International Economic Institute:
  
  Current Account Deficit
  
• Bank of Spain:
  Official Web Site