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Many of the world’s major economies are now in caught a strange paradox. To rescue their financial sectors, they have substituted private with sovereign debt. That, coupled with decades of profligate spending and gigantic bailout packages have resulted in a crushing debt load.
The following chart is from a report by the World Bank showing that G-7 economies in aggregate are fast approaching the debt to GDP ratio they last saw after the Second World War:
Now, just at the point where they need to expand expenditures, the bond market demands higher interest rates and austerity measures from them. If they cut spending, that will reduce their output, lessening their ability to service the debt.
There are a few end game scenarios along a continuum; on the one side we have a (miraculous) recovery and on the other, economic collapse - with perhaps a bleak purgatory of stagnation. The pessimistic scenarios need no real exposition as they are rather obvious.
One possible explanation of how the global economy can pull itself out of this mess is the larger role that emerging economies are playing. According to the World Bank report:
Reflecting much higher productivity and population growth, the economies of the developing world are expected to grow by about 6 percent in all three years, while high-income country growth is limited to 2.3 percent in 2010 and 2.4 and 2.7 percent in 2011 and 2012 respectively. Because of these large growth differentials, developing countries will be a major source of global growth (see chart). Close to half of the increase in global demand in each of 2010 through 2012 will come from developing countries…
When the developed countries’ economies contribution to world GDP shrank in 2009, the developing economies managed to eke out a small net positive contribution. And they are projected to take on slightly more than 50% in the next few years. Already smart asset allocators like Jeremy Grantham are positioned to take advantage of emerging markets. Ever vigilante to the risk of bubbles, he thinks that emerging markets will potentially develop into one but not for a few years. In the meantime he’s invested.
The World Bank forecast takes into account a slowdown in China (as many are expecting):
Developing country growth is projected to pick up from an estimated 1.7 percent in 2009 to around 6 percent in each of 2010, 2011 and 2012. The apparent steadiness of growth in each of these years belies an anticipated slowing of growth in China, the largest developing economy (from 9.5 in 2010 to 8.5 percent in 2011), as the fiscal stimulus put in place in 2009 begins to be unwound. Excluding China and India, developing country GDP is projected to increase by 4.5, 4.4, and 4.6 percent in 2010, 2011, and 2012 respectively.
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