The european economic wreck smoulders, and trouble may be around the corner for the US

Drivers often stop to look at a bad accident on the opposite side of the road. It's human nature. Like motorway drivers, since mid-year everyone has stopped to gape, open-mouthed, at the spectacle of first the Greek, and then the euro financial systems collapsing in slow-motion. The euro road-crash is even better than a motorway crash, because it's still going on, like a horror movie with no director, and no known ending. It's compelling entertainment, in the same way as a game of Russian roulette played with real guns and ammunition.

When the euro crisis does eventually end, will the spectators be able to come down to earth again? Or will they start looking elsewhere for another live show, to feed their appetite for edge-of-the-seat financial drama? Could they start looking for the next big drama in the US?

We've had financial crises before - lots of them. The one that immediately comes to mind is the Asian financial crisis, which started in 1997. Before that, in the early 1990s the Nordic countries had their financial crises. And some countries in South America was in financial crisis all the way through the 1980s and 1990s. But in the boom years of the 1990s and the first decade of the new millennium up to 2008, the idea that a developed Western country could run out of money was unthinkable.

But in 2008, the perception of Western invulnerability changed. For a time after the crash, money printing in the US delayed the inevitable pain to come, giving the false impression the crash was a bad dream, from which we had awoken. But now in Europe the nightmare has returned, as one euro country after another finds its cost of borrowing rising to unsustainable levels. Is a Western crisis the "new normal", and is the US next?

It's important to understand that the fundamental reason for the financial crisis is simply - too much debt. Since 1980, debt in the Western financial system has built up and up, to the point where it's obvious now to everybody that a lot of it is never going to be paid back. The only answer which most Western policymakers can think of is to replace old debt with new debt - kick the can down the road, so that when the problem eventually becomes a crisis again, it's someone else's problem.

Consequently, in Europe, the problem which started with the weaker smaller members of the euro in 2009 and 2010 has now attacked the whole euro system. Most of the euro leadership and many "experts" are pushing hard for the European Central Bank (ECB) to monetize the problem by printing money. We are told that this solution won't be inflationary, and will "give time" for euro governments to cut their spending and reduce their budget deficits to within the 3 percent limit set by European law.

But since 1999 when the euro began, euro governments have shown little willingness to undertake hard budget cuts and economic reforms until absolutely forced to do so by the markets. Will a massive money-printing exercise by the ECB help to bring about the fundamental economic changes that are needed? I think not.

Only the Germans are prepared to undertake the difficult cutting and reforming steps which really can address the European debt problem. Now German Chancellor Angela Merkel has to decide what to do about the large European banks, whose shares have fallen to a fraction to their accounting or book value in recent weeks, forecasting their insolvency.

Will she have the strength of mind to allow the insolvent European banks to write off their bad debts, and then be merged or taken over, perhaps by foreign, even Chinese banks? Only by canceling the debt can the debt mountain be reduced to a manageable level, so that European economies can start to grow again.

The Europeans still have all this ahead of them, but the Americans, who had their crisis first in 2008, have apparently dealt with their problems, restructured their banks and are ready to move on. Or are they? American debt continues to grow. In 2010, as a percentage of GDP, America's net debt ratio of 68 percent was larger than Europe's. Congress recognized the debt overhang as something they had to deal with, but they couldn't manage it, relapsing into party wrangling and ideological disputes. Now the cross-party congressional committee established to agree on a financial package for cutting the US deficit has failed, prompting some to argue that's a good thing, because the automatic spending cuts that will follow are going to do more than the committee would have done to reduce the deficit.

Many Americans are encouraged by signs of returning economic health, with revised annualized economic growth achieving 2 percent in the July-September period and the economy looking on track to achieve 3 percent in the final quarter of 2011. But the US debt problem is getting worse. Although the International Monetary Fund projects the US annual budget deficit to fall from 7.9 percent of GDP in 2012 to 5.6 percent of GDP in 2015, it still projects net debt rising to 88 percent of GDP in 2016.

The US is starting to walk in a dangerous place. It has a considerable advantage of issuing the world's currency, the dollar, so that it can print the money it needs to pay its bills. And it still remains potentially the world's most dynamic large economy. On the other hand, who thought a year, or even a month ago that Germany would have difficulty in borrowing on the capital markets to finance its relatively modest deficit?

The recent announcement that the committee sitting in Washington had failed to agree any proposal for cutting the spending shortfall will have sent a signal around the world's markets, now preoccupied with Europe, that perhaps it's impossible for the US to turn its rising debt levels around. Certainly, it's necessary for US defence spending to fall and for social security to be cut, and also for taxes to rise, in order to get the situation under control. But the message we're getting is that, like Europe, the US will need shock treatment from the markets before its politicians start to get serious about deficit reduction.

What would that shock treatment look like? It would involve a sharp fall in the US dollar together with a rise in medium and longer-term interest rates. These longer-term rates are independent of Federal Reserve policy. Their importance depends on the fact that they determine the prices at which banks lend to US homeowners, and they are also important in setting the prices of other assets such as equities, both in the US and elsewhere. The extent of the rise in US rates may depend on the size of the fall in the dollar, because both these variables affect the rate of return which foreign investors - such as the Chinese government - are looking for when they place funds in the US market. It's possible that a sharp dollar fall of about 10 percent might remove some of the upward pressure on longer-term US interest rates.

But the rest of the world cannot remain untouched by a rise in American longer-term interest rates. China in particular is vulnerable because of the close relationship of the Chinese currency to the US dollar.

It seems inevitable that at some point the markets will turn on the US and its out-of-control debt problem.

The author is visiting professor at the Guanghua School of Business, Peking University. The views expressed do not necessarily reflect those of China Daily.

(China Daily 12/16/2011 page9)