After the Stimulus Binge, a Debt Hangover

Government policymakers from Washington to Tokyo are tallying the bill for last year's stimulus binge, and the results won't be pretty for investors or elected officials. Since the collapse of Lehman Brothers in September 2008, the Group of 20 largest industrialized economies have spent more than $2.2 trillion—much of it borrowed—trying to restore growth.

This unprecedented public debt glut will complicate the global recovery. That's because the government debt entering the bond markets will make it harder for private companies to issue debt of their own, either to expand or simply ride out the lingering effects of the credit crisis.

This so-called crowding-out dynamic, together with rising borrowing costs, will depress job growth. The more that small- and medium-sized businesses are starved for credit, for example, the fewer new employees they will add. The crowding also could lift interest rates for consumers.

That's the downside of a stimulus binge: It pumps up growth initially, but the hangover can be painful across an economy for years to come.

Even assuming some budget trimming, the International Monetary Fund expects government debt in advanced G-20 economies to reach 118% of their combined gross domestic product by 2014, up from 78.2% in 2007, just before the economic crisis took hold. Getting to a more sustainable 60% level will involve raising taxes and cutting services.

President Barack Obama's dilemma is not unique: Raising taxes to reduce debt may delay a solid recovery, while trimming spending too much could erode the social safety net and damage competitiveness in the long run. Either way, he and other heads of state struggling with mounting debt burdens are likely to find economic growth over the next decade slower than in the last.

Japan is a poster child for the Great Reckoning. Asia's biggest economy has little to show for the 30 trillion yen ($329 billion) that the government has pumped into it since late 2008. Unemployment, already at a near-record 5.2%, is edging higher. Meanwhile, deflation is intensifying, wages are stagnant, and worried households are saving more and spending less. Worse, Japan's population is aging rapidly, reducing the tax base and raising social costs.

The most indebted among industrialized nations, with public debt approaching 200% of GDP, slow-growth Japan risks seeing a downgrade of its Aa2 credit rating this year. "Japan is the mega-risk problem. It's the next big thing that will hit credit markets," says Carl Weinberg, chief economist at High Frequency Economics.

Expect both credit-rating agencies and investors in 2010 to be sniffing around for other potential debt troubles, be they in China, Greece, Mexico, Vietnam, or even the U.S. Any move to downgrade credit ratings could shake global markets, boosting mortgage rates around the globe and hurting stock prices.

The unwinding process will keep central bankers like Federal Reserve Chairman Ben Bernanke busy as well. The Bank of Japan and the Fed are holding interest rates near zero, while the Bank of England and European Central Bank aren't far behind. All that liquidity is finding its way into stock and real estate markets from Mumbai to Shanghai to São Paulo, creating fresh bubbles and increasing the risk of inflation.

But the debt burden makes it harder to move rates back to more normal levels, since boosting borrowing costs will increase that even more.

Other nations will be set back in underappreciated ways. What economies like India, Indonesia and the Philippines have in common are young populations. Unless you create opportunities and well-paid jobs for them, these societies risk becoming breeding grounds for greater poverty and violence, the most unwelcome part of the Great Reckoning.

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