Next Round of the Financial Crisis May Drag Down Governments

There's plenty of evidence today to suggest that governments around the world are feeling the strain of two years of unabated financial crisis and bailouts. Standard & Poor's cut the outlook on Spain's credit rating to negative from stable because of rising budget deficits and a weakening economy, Bloomberg reported. In January, S&P reduced its rating on Spain's debt to AA+ from AAA. "Bonds from Dubai to Greece have tumbled in the past two weeks on concerns that some governments will struggle to patch up their finances after the worst global recession since World War II. Greek 10-year government debt today slid for the fifth straight day as the European Union and other member states put pressure on the administration to rein in its deficit, set to be the highest in the EU this year at 12.7 percent of economic output," Bloomberg reported in a piece by Emma Ross-Thomas. The sovereign troubles are furthest along in Greece. The wire service reported today that "Fitch Ratings said Prime Minister George Papandreou’s government doesn’t grasp the debt crisis’ severity." But lest we think that all the sovereign presssures are abroad, there is troubling news today, also via Bloomberg, that "U.S. state government collections fell 16 percent, to almost $1.7 trillion, in fiscal 2008 from a year earlier, while spending increased 6.2 percent, according to the U.S. Census Bureau."

So far, the response to the financial crisis has been a game of hot potato. The cost of bad debt has been passed from one hand to another, with the net result being a shift in burden from the private sector to the public sector. This process continues even now. In the U.S., Treasury Secretary Tim Geithner said today that the financial-rescue program will be extended until October, although he doesn't expect to use more than $550 billion of the $700 billion in funds.

We now face the risk of a troubling new twist to this game, in which stronger governments will bail out weaker governments. The United Arab Emirates is backing member state Dubai, and if Greece moves further along the road to default, the EU could be forced to bail out a weaker member state. And California could be a prime candidate for federal government aid in the U.S.

What are the odds of default? In most cases, probably not too high, although I bet that holders of Greek sovereign credit are pretty nervous. Yet default isn't the only risk. Governments around the world are under increasing pressure to avoid default, and that means cutting back on spending to bring their deficits under control. Those cutbacks are difficult to achieve because they will trigger significant political backlash, which is generally understandable. Even if the cutbacks are put in place, they are likely to depress global economic growth just as the world is moving out of recession. And a slowdown in the economy is likely to lead to lower government revenues, which will in turn put more pressure on weaker governments when it comes time to pay down debt.

There are still plenty of systemic risks in the global financial system, and they are shifting to the massive public sector. If those risks spread, the financial and economic fallout could be enormous. The political fallout could be huge, as well. It's likely to be a defining issue in 2010.