By Patrick Artus

We know the first wave ― or the first group ― of countries hit by a public finance crisis, i.e. the peripheral euro-zone countries: Greece, Portugal, Ireland, Spain and Italy. These countries showed a double imbalance in their public finances due to very substantial fiscal deficits, and in their external accounts due to their massive current-account deficits. Even now, the external deficit is as high as 10 percent of gross domestic product in Spain and Italy, while Ireland has eliminated its external deficit.

Even though these countries’ situation is serious, we hope that they will gradually pull out of the crisis, something the financial markets and investors do not believe yet, except perhaps with respect to Ireland.

The situations of Greece and Portugal are the most serious in this group of countries. As we have seen, they have a huge external deficit, which is due to the structure of the economy and not only to their fiscal deficits. These are highly de-industrialized countries, whose imports are more than twice as large as their exports: only 7 percent of the labor force works in industry in Greece, versus close to 20 percent in Germany. These two countries will only be able to pull out of the crisis with the help of Europe, and also by having part of their public debt cancelled, which has just been organized for Greece with the 50 percent haircut. Obviously, these two countries would also have to reduce their fiscal deficits and accept a reduction in the part of domestic demand that domestic production cannot meet: from 1999 to 2008, gross domestic product in real terms in Greece increased by 50 percent, while consumption increased by 80 percent.

The cases of Spain, Italy and Ireland are a little less problematic. In Spain and Ireland, foreign trade has already improved significantly: the external deficit has disappeared in Ireland, while it has declined from 9 to 4 percent of gross domestic product in Spain. This is due to a reduction in fiscal deficits, a fall in wage costs ― and hence to an improvement in competitiveness, which has paved the way for a sharp upturn in exports ― and a reduction in domestic demand. Italy, for its part, is a large industrial country with dynamic companies: there are as many exporting companies in Italy as in Germany, i.e. 250,000.

Excluding energy, it has a foreign trade surplus and the current budget has a primary surplus, excluding interest payments on the debt. So Italy is obviously solvent, and Mario Monti’s government seems prepared to implement the structural reforms required to boost long-term growth.

It is therefore reasonable to believe that the countries in the first wave of troubled countries including Greece, Portugal, Ireland, Italy and Spain, will gradually pull out of the crisis; in the case of Greece and probably Portugal, this will require a default on a substantial part of the debt. Even so, would this bring

the public debt crisis to an end? We do not believe so, as a possible second wave of countries could very well slide into a crisis due to their public and external debts.

First and foremost, this concerns France, the United States and the United Kingdom. The characteristics of these three countries resemble those of the peripheral euro-zone countries: twin deficit, external and fiscal; drastic deindustrialization which explains the trade deficits, weakening growth and rising unemployment. Manufacturing employment accounts for only 8 percent of total employment in the

U.S. and the United Kingdom and 11 percent in France, which is at the same level as the euro-zone countries facing severe problems. A recovery in these countries’ economy would require, in addition to a reduction in fiscal deficits, more restrictive monetary policies in the U.S. and in the United Kingdom aimed at driving up the savings rate. However, these same countries are actually implementing ultra-expansionary monetary policies aimed at jump-starting demand or at driving down

their exchange rates. In France, all obstacles to company growth would have to be removed, which would require a tax reform to reduce the weight of welfare contributions, a fundamental change in the relationships between large groups and small businesses and an improvement in the sophistication and quality of industrial products. This will all take a long time.

There are also grounds for concern about the medium-term outlook for Japan. The high public debt, which exceeds 200 percent of gross domestic product, is financed at a very low interest rate only because there are excess domestic savings in Japan and because these savings are lent to the government at very low interest rates. All the developments that could lead to an external deficit for Japan, such as a long-lasting global slowdown or population ageing, would force Japan to borrow from

the rest of the world, inevitably leading to a steep rise in interest rates that would have a catastrophic effect.

We can see that even if the first wave of troubled countries ― Greece, Ireland, Portugal, Spain and Italy ― succeed in pulling out of the crisis, they may be followed by a second wave: France, the U.S., the United Kingdom and even Japan. The case of the U.S. is obviously particular since the dollar’s status as the dominant reserve currency gives the U.S. the possibility to easily obtain financing for its deficits from central banks in Asia, the Middle East and Latin America.

But will the central banks themselves one day not worry about the U.S. becoming insolvent?