Economy: Debt and Politics

Rail workers rally against pension reform in Paris, October 2010. Fred Dufour / AFP-Getty Images

Global leaders may not have much time in their schedules for Broadway shows, but it's their loss if they've missed Al Pacino's star turn on Broadway as Shylock in The Merchant of Venice. Still, it's not the only riveting debt-related drama to see. "All the world's a stage," Shakespeare wrote in As You Like It. And this coming year, the global economy is likely to provide a vast stage for clashes, challenges, crises, and triumphs over the world's $82 trillion in debt.

Until now, power has been defined largely by military strength, by control of vital resources like oil, or by the ability to embrace a form of supercharged capitalism, like China. But in 2011 and coming years, the ability to manage debt may be the best indicator of where global economic power resides. Back when George W. Bush was president, his "freedom agenda" was about democratic elections and ending one-party rule in the developing world. Now the No. 1 issue has become freedom from crippling debt and restoring fiscal balance in the developed world. Who will ring out 2011 in better shape than when it began? Those who can best manage the brutal deleveraging process in the advanced economies, those who can use the currently forgiving conditions to rebalance, and those not lured into fresh crisis by easy money.

Debt has always been two-edged, which is one reason Shakespeare could exploit it for such dramatic effect. One woman's liability is another woman's asset. Debt is leverage, a force multiplier that lets you lift something (a car, a company, an entire consumer economy) larger than you could under your own power. As such it's a huge spur to freedom. For consumers at the bottom of the pyramid, microfinance has become a form of liberation theology. But debt can also limit one's freedom—it's a shackle, a contract. They're called bonds because they bind parties together. Ever since the onset of the crisis in 2008, this latter sense has assumed primacy. Debt, it turns out, can be a liability for the borrower and the creditor, especially when it goes bad. It can restrict action, and impose harsh terms on those who have taken on too much.

Until recently, when economists spoke of "decoupling," they were talking about a dynamic in which the growth rates of countries like China seemed to be disconnected from those of the U.S. and Europe. Today the decoupling is between those countries that are hamstrung by debt and those that are not. Consider the differential growth rates of the highly indebted, highly developed lands (the U.S., Europe, and Japan, bumping along at unsatisfactory paces) and those of the less-indebted developing countries like China, India, and Brazil, where consumers devote a rising share of their rising incomes to consumption—a virtuous circle that promotes growth. Meanwhile, the debtor lands are strapped by austerity, budget cutting, and deleveraging. That's why, as Kenneth Rogoff and Carmen Reinhart note in their influential book This Time Is Different, economies coming out of recessions induced by financial and debt crises have slow recoveries.

Debt is transforming politics and geopolitics. It's a strange world where Argentina and Brazil look like models of fiscal probity, while Europe and the United States struggle mightily to get a handle on financial affairs. The term "failed states" used to mean countries like Somalia that couldn't govern their own territory. Now it encompasses those that have lost control over their own financial affairs, like Greece. The bond markets, by manifesting doubt about Greece's ability to fund itself, did what no one else could: force the country to undertake serious reforms. Greece has become an object lesson for countries with overgrown deficits. As that country learned the hard way, a functioning tax code can be as essential as an effective military and police force. Threats to sovereignty now come not from domestic insurgents but from international investors.

Instead of vanquishing military foes, today's statesmen are called on to knock down debt. In fact, to cut Britain's red ink, Prime Minister David Cameron is sharply reducing defense spending, even if that could reduce the country's capacity to engage in any future Afghanistans. Cameron strikes a Churchillian tone when he talks about the nation's austerity plans. As he took office in May he warned the British public that the country's most urgent issue ahead was "our massive deficit and our growing debt. How we deal with these things will affect our economy and our society, indeed our whole way of life." Call it the Battle of the Fiscal Bulge.

Debt reduction is no longer the contemplative realm of policy wonks and bean counters. The first knockdown political fight between the new Congress and President Obama won't be about health care; it will be on the vote to increase the $14.3 trillion public debt limit. And fury is rising in Beijing over America's willingness to run huge deficits and expand the Fed's balance sheet. (Fortunately for U.S. investors, the Chinese central bank's enormous holdings of U.S. government debt—currently some $868 billion—in some ways constrain Beijing from taking actions that might imperil them.)

The global economy these days is like a race in which debtor nations are trying to sprint with leaden weights around their ankles. By contrast, the wind is at the backs of countries with high savings rates and comparatively low levels of consumer, corporate, and government debt. But they also need to be wary. Tens of millions of people in the growing economies are joining the middle class—and acquiring credit cards, mortgages, and bank lines of credit. China's leaders may scold America, but reports of ghost towns of unoccupied apartment towers and an opaque banking system suggest that China's credit-management skills are less than stellar.

But as sovereign nations struggle with debt, corporations are thriving. Companies around the world have cashed in on lower interest rates to refinance their way out of trouble. Standard & Poor's reports that the number of corporate defaults—big firms failing to make payments on bonds—fell dramatically in 2010, with only 68 through November, compared with 250 for all of 2009.

The world's current debt troubles surfaced first in the private sector, with the 2007 subprime-mortgage crisis. But even in the United States, the most spendthrift of nations, the private sector finally got religion. The savings rate continues to hover above 5 percent, and the outstanding balance of revolving credit (credit cards and the like) fell from $957 billion in 2008 to $822 billion in August 2010. Household debt in the U.S. fell for nine straight quarters through the second quarter of 2010.

Before the crisis, investment banks operated with $20 or more of debt for every $1 of capital. Savings and low leverage were for old people, for the Chinese, for killjoys and chumps. Now the combination is a competitive advantage for the Masters of the Universe. In JPMorgan Chase's earnings report for the third quarter of 2010, CEO Jamie Dimon, America's most influential banker, touted the bank's lack of leverage while crowing about earnings. And after all, who can blame him?

And there's more to come. In the name of promoting stability, the international banking community's Basel III regulations are likely to squeeze more debt out of the global financial system. And the scene has shifted from private to public sector. The big question remains how the United States, the world's largest economy and for decades the consumer of last resort, will cope with its large public debt. Thus far, the world's investors have proved willing to extend seemingly unlimited credit to America on extraordinarily easy terms. But credit comes from a Latin word meaning belief. And belief in an institution's creditworthiness—or a country's, or a person's—can evaporate overnight. Ask Lehman Brothers, or Greece.

So you won't need Broadway tickets to see a heart-wrenching, debt-related drama in 2011. All around us, heavily indebted developed countries are trying to avoid reenacting Greek tragedies, while rapidly developing economies seek to forestall a comedy of errors. The last word on the subject rightly belongs to Shakespeare—not from The Merchant of Venice, but from Hamlet: "Neither a borrower nor a lender be."

Gross Is Economics editor at Yahoo Finance.