How The Remedy To One Crisis Might Cause The Next

Will the solution to the last financial crisis cause the next in a wave of sovereign debt defaults? Economist Nouriel Roubini and the World Economic Forum are the latest to sound the alarm.

Over the last two years developed countries kept their economies afloat with a flood of borrowed money. Now investors are getting nervous about sovereign debt levels, forcing some nations to make a painful choice: stop borrowing, cut spending or raise taxes -- or craft some combination of the three.

Roubini and co-author Arpitha Bykere write in Forbes:

In 2009, downgrades and debt auction failures in countries like the UK, Greece, Ireland and Spain were a stark reminder that unless advanced economies begin to put their fiscal houses in order, investors and rating agencies will likely turn from friends to foes.

And in its Global Risks 2010 report, ahead of the annual meeting in Davos later this month, the WEF also notes:

In response to the financial crisis, many countries are at risk of overextending unsustainable levels of debt, which, in turn, will exert strong upwards pressures on real interest rates.

Greece may be the biggest trouble spot in the near term, if credit default swaps are any indicator. The Financial Times notes that Greek CDS now indicate a higher probability of a default in the short-term than in the longer term -- a reversal from a week ago -- following comments by the European Central Bank President that the country won't be getting any special treatment.

To fight a recession, you have to spend and loosen monetary policy. To fight investor fears, you have to save and tighten monetary policy. What happens if you try to accomplish both? BusinessWeek reports:

Strikes are planned in Greece, laborers in Spain have balked at lower jobless benefits, and Irish workers have taken to the streets to protest the cutbacks.

One solution is gradual tax hikes as soon as 2011, Roubini argues. Another is painful spending cuts, as George Magnus, a Senior Economic Adviser at UBS Investment Bank, wrote yesterday in The Financial Times. Governments, he argued:

should raise the pensionable age, tackle public sector pension arrangements, and blaze a trail towards higher labour force participation and phased retirement patterns.