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Spreading inflation speeds up the debt repayment clock

It came as a stark reminder that U.S. profligacy can't continue forever.

The admonishment by credit-rating agency Standard & Poor's that it might cut Uncle Sam's cherished triple-A rating rocked Washington this week, as markets absorbed the staggering debt numbers afresh: The United States owes its creditors $14-trillion and change, a figure that is approaching 70 per cent of gross domestic product. And while there are duelling, widely divergent proposals for dealing with the costly tab, the world's biggest economy still has no official plan for digging itself out of the red.

The S&P wake-up call about the U.S. debt comes amid increasing signs that the euro zone's fiscal woes are likely to result in one or more nations defaulting on their debt, as the world's advanced economies face up to the cost of having averted a global depression.

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And they're going to have to pay off the tab at higher interest rates.

Central banks in advanced economies are preparing to push interest rates up from emergency-low levels, and the U.S. Federal Reserve is poised to end its two-year program of injecting cash into the financial system. At the same time, emerging-market giants like China are struggling to keep a lid on inflation rates that are helping to fuel price gains around the world.

The developing world's economic growth was fuelled in part by the government spending binge aimed at restoring consumer demand in rich countries. Now, the same global inflationary pressures that have already caused energy and food costs to soar threaten to bring tighter monetary policy to advanced economies more quickly than many expected, as the two-speed recovery continues to play out.

And the rising cost of shouldering sovereign debt is coinciding with what many expect will be a long stretch of underwhelming growth and relatively high unemployment. Sluggish growth and aging populations will hamstring governments' fiscal manoeuvrability for years. "It's really a burning platform right now or, at least, smouldering," Glen Hodgson, chief economist at the Conference Board of Canada in Ottawa and a former official at the Finance Department, said in an interview. "For most industrial countries of the world, they have to have a plan to take control of their destiny." As the Bank of Canada's Mark Carney often says, the easy part of the recovery is long past.

Mr. Carney and other policy makers and economists warn that debt-saddled governments - much like households - can't afford to wait before starting to pay the tab, because waiting will just make the task harder. Those annual budget shortfalls that seem manageable while borrowing costs are low pile up and, eventually, the interest costs on the accumulated debt can cripple a government's ability to do much else.

The slow but sure tightening of conditions will come against a backdrop that's very different from that of the last expansionary cycle, when China actually helped temper inflation by flooding its trading partners' markets with cheap goods.

According to David Watt, a senior currency strategist at RBC Dominion Securities, that means eventually money could be harder to come by in funding markets, adding to the upward pressure on the yields investors demand to buy certain countries' debt.

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Some of the most highly indebted European Union governments have crafted and started to implement debt-fighting plans - in order to secure or, in some cases, avoid bailouts.

Not every developed country has America's twin problem of exponentially rising entitlement outlays and a political culture that abhors tax increases. But almost all face a similar threat of endless structural budget gaps, as baby boomers retire, collecting pension benefits and straining health care systems that will be stretched more each year as birth rates decline, work forces shrink and revenue dries up.

Urging advanced economies to get their debt loads down to "prudent levels" in the medium term, the International Monetary Fund forecast in mid-April that for the first time since the Second World War, those nations' average domestic debt ratio will top 100 per cent of GDP, rising to 107 per cent five years from now. That would be 34 percentage points higher than before the U.S. financial crisis went global.

The U.S. shortfall for this year alone will reach almost 11 per cent of GDP, more than earthquake-ravaged Japan and more than Britain, where David Cameron's government has won praise for pushing through some of the most brutal belt-tightening measures in a generation - sacrificing short-term economic growth and, possibly, medium-term political support.

To be sure, there is a strong case to be made that the buckets in additional spending helped prevent another Great Depression and limited the pain for hundreds of millions of people around the world.

For financial market players, though, that's somewhat academic.

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"The Keynesian economists would say it's the worst possible time to stop spending money, because you'll choke off the recovery, and the right-wing economists would say most of that money isn't doing you any good, and you have no choice but to deal with the debt," said David Baskin, president of Baskin Financial Services Inc. in Toronto. "My own view is that the Americans and the Europeans have to deal with the debt at this point. It's kind of past choosing time, and the S&P thing is a shot across the bows."

At the same time, there are important differences among the indebted countries. In Europe this week, even as bond yields soared for Greece and Portugal, and the cost of insuring debt sold by those countries rose to records, there were encouraging signs that measures taken by much bigger Spain will help it avoid becoming Ground Zero for a far more frightening continent-wide crisis.

Also, while the U.S. dollar's decline is a reflection of general concern over America's finances, few expect that two biggest holders of U.S. Treasuries - China and Japan - will start dumping their holdings en masse any time soon. With a younger population than most advanced economies, mind-boggling wealth, and still one of the most dynamic, productive labour forces on the planet, it's hard to imagine the United States not finding some way to raise revenue and reduce its swollen obligations.

/As long as political brinkmanship doesn't get in the way, that is.

"The real deficit in the U.S. is in political will, and the acrimonious political climate that we have," said Nariman Behravesh, chief economist with IHS Global Insight of Lexington, Mass., one of the world's largest forecasting firms. "But I think in the end, politicians' minds will be focused, and you can give a little credit to S&P on this." To hear Mr. Behravesh tell it, the S&P warning might provide some timely political cover for both sides to embrace revenue-raising measures that also serve other long-standing U.S. needs. For example, a bipartisan effort to sell the public on a higher tax on gasoline - however counter-intuitive it may seem - could bring in billions, while helping the environment and reducing America's reliance on foreign oil.

Canadians can only hope that is the case, since it's clear that, as the world's biggest consuming nation, ever-rising debt in the United States would crimp growth throughout the global economy. At the very least, the S&P warning has put a spotlight on the importance of fiscal solvency at a crucial point in the rebound. The commodity-fuelled inflation that this week led to a trucker strike in Shanghai, China's busiest port, also recently forced the European Central Bank to raise borrowing costs even as many EU nations desperately struggle to stay afloat.

The Bank of Canada's Mr. Carney could be pushed to raise rates by this summer, even as he frets about the commodity-fuelled Canadian dollar's effect on exports.

As Mr. Carney warned late last year, governments have to face up to the fact that the easy part of the recovery is over, and do whatever they can now to avoid a harder reckoning later.

"Cheap money is not a long-term growth strategy," the bank governor told a business audience in Toronto in mid-December.

"While low current interest rates create short-term fiscal flexibility, they expose budgets to any increase in policy rates and abrupt changes in private market sentiment. Countries would be wise to heed the lessons learned by Canada in the 1990s: The bond market is there until it is not.''

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About the Author
Economics/business writer

Jeremy has covered Canadian and international economics at The Globe and Mail since late 2009. More

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