Investors can be forgiven if they have a sense of déjà vu about the conditions in global financial markets: stock markets in turmoil, the world’s central banks banding together to keep credit markets running, hastily arranged weekend bailouts and regulators banning short-selling.

Although all this sounds a lot like what happened in the depths of the financial crisis of 2007-08, all those elements are back as the second phase of the crisis rears its ugly head.

The financial crisis that got its start back in 2007, intensified in 2008 and ebbed last year has resurfaced this year as a sovereign-debt crisis. When the initial turmoil hit in 2007, it was largely bank balance sheets and global financial services institutions that were affected. Governments were called on to bail out the financial system in much of the developed world as economic growth plunged and fears of a far bigger crisis arose.

Although the worst-case scenario was avoided, the lingering effects — both the resulting economic fallout and the costly government response — are not going away. Indeed, the threat of debt default in Europe has intensified strains in financial markets once again, leading to a replay of many of the events that marked the heights of the initial crisis.

Stock markets have become exceptionally volatile. Leading central banks, including the Bank of Canada, have reopened emergency swap lines with the U.S. Federal Reserve Board to ensure liquidity in money markets. The European Union has cobbled together a backstop package, worth an estimated US$1 trillion, to support its faltering members. And, most recently, Germany’sFederal Financial Supervisory Authority has surprised markets with a temporary (in effect from May 19 2010, to March 31, 2011) ban on naked short-selling of a handful of financial stocks and eurozone debt, and on certain credit-default swaps on European debt.

It’s all starting to feel uncomfortably familiar — although, if anything, the stakes are now higher because this latest wave of turmoil is focused on the balance sheets of sovereign nations rather than individual banks’ balance sheets.

“The parallel with the [earlier] financial crisis is not necessarily leading to a similar outcome as Lehman Brothers Holdings Inc. and Bear Stearns Cos. Inc., but it is nevertheless ominous,” acknowledges a research report from Toronto-based credit-rating agency DBRS Ltd. “In some ways, governments are like financial institutions in that a loss of market confidence, even despite a well-constructed fiscal plan or prospects, causes investors to flee.”

But it’s questionable whether many governments in developed economies have sound fiscal plans or solid growth prospects. Although many of the actions that countries originally took to stave off the collapse of the financial system seemed to work, the events of the past couple of years, when combined with looming demographic pressures (aging populations, which presage lower economic growth, and higher public pension and health-care costs) and the unresolved underlying structural problems that led to the crisis in the first place (unsustainable household debt burdens), have left public finances in rough shape. The fear is that countries will default on their debts, causing big losses in financial services institutions, thus imperilling the financial system all over again.

Certainly, public finances in many developed countries are not in good shape. A a recent report from the International Monetary Fund says the average gross government debt/gross domestic product ratio for advanced economies was almost 91% at the end of 2009. It’s expected to rise to almost 98% this year and to 110% by 2015. Canada’s gross debt/GDP is forecasted to reach 83.3% this year.

As well, the IMF report says, these risks have risen in recent months because underlying fiscal trends have deteriorated, financial markets have intensified their focus on these issues and governments haven’t made enough progress in defining their plans to improve their finances.

“While a widespread loss of confidence in fiscal solvency remains, for now, a tail risk, its potential costs are such that the risk should not be ignored,” the IMF report says. “Even in the absence of such a dramatic development, without progress in addressing fiscal sustainability concerns, high levels of public indebtedness could weigh on economic growth for years.”

Certainly, some of the ways in which governments typically improve their finances don’t look feasible right now. The DBRS report notes that in the 1990s, governments were able to ease their debt burdens by selling off state assets, cutting spending, taking advantage of lower real interest rates and through economic growth, which boosted tax revenue.

Indeed, it appears some stronger than expected economic growth is already enhancing Canada’s fiscal outlook, according to the latest data from the federal government. As a result, a Toronto-Dominion Bank report says that it appears last year’s projected $53.8-billion deficit (as forecast in the last federal budget) is likely to be closer to $46 billion-$47 billion (3% of GDP).

Moreover, with this better starting point, the TD report says, the federal government could get its budget back in balance faster than anticipated. Assuming the government does allow the existing fiscal stimulus efforts to expire as planned and that it manages to restrain spending growth as promised (to about 2% per year, starting in fiscal 2012-13), the TD report says that Canada could return to a surplus by 2014-15 and that the debt/GDP ratio would also be a bit lower than anticipated as a result.






@page_break@Of course, a lot can happen in the next five years. Much of this forecast is dependent on the government following through on its promised spending restraint. Although recent economic growth may have been robust, the expectation is that the overall recovery is going to proceed at a fairly modest pace. And, if the first wave of the financial crisis has taught us anything, it’s that a relatively small, open economy such as Canada’s is particularly vulnerable to global economic forces.

The BofC’s latest Monetary Policy Report — published before the concerns over Greece and the rest of Europe reached the full-blown crisis stage — cites sovereign credit concerns as a primary downside risk and warns it could lead to higher borrowing costs and more rapid tightening of fiscal policy in some countries, restraining global private demand by more than expected.

Moreover, Canada may have a lurking debt problem of its own, beyond government finances, that could yet dampen domestic demand. Household debt levels have been growing uncomfortably for some time. A report from the U.S.-based McKinsey Global Institute earlier this year singles out Canada as a country facing a high likelihood of household deleveraging and warns that such periods tend to be protracted and painful.

A new Certified General Ac-coun-tants Association of Canada report confirms the increasingly perilous state of Canadian household finances. It says that the level of household financial stress has increased over the past couple of years, with the debt/income ratio reaching a new high of 144.4% at of the end of 2009 and the debt/assets ratio up to 19.4% from 15.2% over the period from 1990 to 2007.

“There is little doubt,” the CGAAC report concludes, “that the level of financial stress on Canadian households has increased and that further run-up in household debt without a corresponding growth in assets and/or income will continue to exert a circular pressure on the economy and on financial systems.”

Even if the current crisis is averted, the other major developed economies that are struggling with debt burdens of their own aren’t likely to be sources of robust demand. The DBRS report observes that many of the traditional escapes for debt-laden countries are probably now limited, pointing out that: interest rates can’t get any lower in most developed economies; there are few state assets left to sell; spending is hard to cut because of the large, and growing, costs of health care and old-age security for aging populations; and robust economic growth seems unlikely at a time when governments, business and households are all trying to deleverage.

Although governments may not be able to spark robust economic growth, or conjure up state assets to sell, they always have the power to cut spending and/or raise taxes. The question is whether they have the will to see either of these unpopular measures through.

For countries seeking to raise revenue, the IMF report recommends hiking taxes that are relatively less distorting — taxing consumption, alcohol and tobacco, carbon and property — as well as cracking down on tax evasion.

In the short term, the aggressive European bailout and the efforts to flood the markets with liquidity are designed to stem contagion from Greece, the region’s most troubled country, to other nations with fiscal challenges. But, as most analysts point out, they do nothing to fix the underlying problems. Which is where convincing government action comes in. Governments in some of the most troubled countries in Europe are introducing austerity measures as part of the region’s rescue package, although it remains to be seen how aggressively they will be implemented in the face of social and political resistance and whether greater turmoil can be avoided.

Notwithstanding some of the fundamental similarities between the current market conditions and those that prevailed at the height of the financial crisis in the autumn of 2008, the two situations are not the same, argues a research report from Bank of America Merrill Lynch, which points out two big differences between the current situation and the earlier crisis. For one, the developed economies were already stagnating when the crisis first hit; now, they are rebounding. More important, the underlying losses that touched off the run on the banks in 2008 were real, whereas they may not materialize in the sovereign debt that has investors so worried.

The report says that whether there are actual losses or not will depend on the political will of governments to make their fiscal positions sustainable. If they do, sovereign debt won’t have to be restructured and financial institutions won’t have to suffer losses. Says the report: “All in all, we think that history will not repeat itself here. Chances are the eurocrisis will get resolved faster than the post-Lehman crisis, and that the overall economic damage will be much smaller.” IE