08/09/2011 03:26 pm ET Updated Oct 09, 2011

Deja Vu All Over Again

Many people are worried about the recent sharp declines in stock markets around the world along with increasing turmoil in other markets and ominous indications of increased violence and political malice.

This is indeed a proper time to be worried. Reductions have barely begun in the debt issued during the global credit boom that crashed in 2008. As long as massive debt burdens remain, governments and households will limit their spending in an effort to retire debt. But if everyone tries to save more, the result is that everyone spends less and everyone else has less income out of which to save anything. This is the box in which the economies of the world's richest countries have been stuck since 2008. Indeed, government debt has dramatically increased, partly because of reduced tax revenues out of reduced economic activity, partly because of bailouts and guarantees to banks and other financial institutions and partly because of all-too-modest efforts to stimulate the economy with more spending or tax cuts.

The sovereign debt crisis that is now unfolding has been a frequent second act in many previous financial crashes. Eventually, government debts, financial sector debts and household debts will have to be reduced to a large extent by failure to pay some or all of the amounts due. So far this has only happened in the U.S. home mortgage market through a large number of defaults, foreclosures and occasional restructurings. It remains anathema to the still incredibly strong banking and investment industries to contemplate similar defaults by European governments or by anyone else the banks have lent money to, or by the banks themselves. At the same time it is clear to almost everyone else that the quickest way to end the European sovereign debt crisis would have been to allow Greece to exchange a much reduced amount of new debt for its probably unredeemable existing debt; and to allow Portugal and Ireland to implement similar solutions.

Instead European governments and multi-national institutions continue to pursue bailouts for bondholders and more drastic punishment for ordinary workers. The anger and frustration that this foments erodes social cohesion, generates violence and further paralyzes the political process. Thus, the Tea Party gains strength even if it is a source of the problem and neo-fascist parties across Europe continue to enlarge their political base and violent presence on the street, making it more possible that they might take power in several countries.

Meanwhile postponement has led to debt crises for Italy and Spain, each larger and with more solid government finances than the original victims. Today the European Central Bank is purchasing the bonds of these two governments and the Eurozone governments have pledged to do the same as soon as their legislatures approve. Followed to its logical conclusion this endless use of the best credit available to bailout bankrupt banks and governments, will lead to a sovereign debt crisis for Germany itself.

In the United States, the recent debt ceiling cliff hanger was a repeat of the theatrical illusion performed in the budget debate earlier this year. Then, Obama, the Tea Party and every politician in between agreed that they had cut $39 billion out of this year's federal government outlays. The Congressional Budget office concluded that the cuts were really a little over $300 million or less than one percent of the amount claimed. Now, the two sides have solemnly passed a bill to cut about $900 billion out of spending over the next ten years, most of it not until six or more years in the future and none of it specified as to which expenditures will be cut. In addition they have agreed to appoint a bipartisan committee to propose additional cuts (or in theory tax increases) amounting to another $1.2 trillion. In short they have not cut one penny from the amount to be spent over the next ten years, although they certainly will get around to some of it before the end of the year. No cuts in spending are certainly less bad than real cuts for the current weak economy; but the absence of clear engagement with reality and a functioning government process are close to the true heart of our current problems.

It is this political make-believe and paralysis that prompted Standard and Poor's to slightly lower its rating of US government debt. And it is proof of their correct analysis that Obama, Secretary of the Treasury, Geithner, and other members of the President's economic team have been pointing their fingers at the rating agency, claiming it made a two-trillion-dollar error that the White House corrected, but still went ahead with its downgrade. This was not an error of "arithmetic" as the White House claims, but an exercise of good judgment in selecting which of a vast array of "baseline" deficit projections to use to calculate the possible savings from the new legislation.

Choosing and fudging baselines is the heart of the Washington shell game. For example, if you assume that the wars in Iraq and Afghanistan will go on forever in your baseline, and then you assume that they will end in your legislation, you can fill your deficit reduction piggy bank with hundreds of billions of dollars. S&P chose the baseline that most people outside of Washington think is realistic rather than the "official" baseline. So, they subtracted the new "savings" from a projection that was two trillion dollars higher than Obama's. But the foundation for the ratings downgrade was the doubtfulness of the process as illustrated by the baseline game, rather than the size of projected future deficits, which have been rendered quite unpredictable by the same political process.