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The G-20 meetings this month, first in Busan, South Korea for finance ministers, and later this month in Toronto for heads of government, mark the moment when the major players in the world economy shift gear from budgetary stimulus to retrenchment. Not everyone is in agreement about this.

Before the Busan meeting, United States Secretary Tim Geithner warned against “a generalized, undifferentiated move to pull forward consolidation plans,” and emphasized the need to “proceed in step with the strengthening of the private-sector recovery.” But the other finance ministers did not echo Geithner’s warnings. Instead, they emphasized the “importance of sustainable public finances” and the need for “measures to deliver fiscal sustainability.” Gone is the stress on cautious, gradually phased-in exit strategies; the search for a rebalancing was almost unnoticeable in the meeting’s communiqué.

This change affects Europe first and foremost. Shortly before the Busan meeting, the countries of southern Europe announced major consolidation efforts in the hope of soothing debt markets. Soon after this, British Prime Minister David Cameron announced “years of pain ahead,” German Chancellor Angela Merkel outlined a $100bnretrenchment plan, and French Prime Minister François Fillon a similar $80bn plan. .

The advanced countries face a dismal budgetary situation, with deficits averaging of 9% of GDP in 2009 and the prospect of public-debt ratios rising from roughly 70% of GDP prior to the crisis to more than 100% of GDP in 2015. According to IMF calculations, to reach a 60% debt ratio in 2030 would require a budgetary adjustment of almost nine percentage points of GDP on average between 2010 and 2020. While some countries in the past undertook adjustments of similar magnitude, a generalized consolidation of this sort is without precedent I.

How painful will the adjustment be? In the past, some countries have enjoyed tearless consolidation, because the launch of a retrenchment program was accompanied by a drop in long-term interest rates, a decline in private savings, or a surge in exports thanks to exchange-rate depreciation (or all of these at the same time). But conditions today are characterized by low interest rates and high private debt, so none of these are likely to help, except possibly for exchange-rate effects. Indeed, depreciation has already started for Europe, and many observers consider the euro’s fall, from 1.5 dollars in late 2009 to 1.2 dollars in recent days, sufficient to offset in the short term the retrenchment’s negative impact on growth.

But this can work only as long as the US does not follow suit and continues to serve as consumer of last resort. This may not happen. Even if the US further postpones retrenchment, the US Congress is unlikely to tolerate an appreciation of the US dollar that makes European exporters more competitive and shifts the burden of sustaining the recovery onto US consumers.

More importantly, increasingly nervous bond markets will at some point start questioning the sustainability of US public finances. The US fiscal position is no better than that of major European countries like Germany, France, or the United Kingdom; in fact, it is worse. It is only because the EU is fragmented, so markets started off by questioning the solvency of the weakest countries within it, and because Europe does not benefit from a safe-haven effect that it was the first to suffer the pressure.

Fortunately, the public-finance situation is entirely different in the developing world, which in some cases has been hit by capital-flow reversals stemming from the collapse of world trade, but does not face an internal adjustment challenge. While domestic credit booms may be a threat in the future, emerging-market banks have mostly remained immune from the fallout of the financial crisis. As a result, domestic non-financial sectors do not face the prospect of deleveraging.

More importantly, the fiscal challenge for these economies is of much lower magnitude than in the advanced world; in fact, it barely exists. The starting points are a 40% public debt-to-GDP ratio and an average budget deficit that, as a share of GDP, is four percentage points lower than in the advanced world. Against the background of much faster potential growth, only a minor effort is needed to keep the debt ratio around the 40% level.
So, what if Europe and the US both enter a phase of prolonged budgetary adjustment while the emerging world stays on course? What if the divergence between the North and South within the G-20 widens further?

Four consequences are likely.

First, there will be a significant drag on world growth. Whatever the emerging world does to sustain domestic demand and reorient exports from advanced countries to other emerging countries, the European and US elephants (not to mention Japan) are just too big for their illness to have no effect on world growth.

Second, the growth differential between emerging and advanced countries will widen, which will in turn intensify flows of capital and skilled labor towards the developing world.

Third, the advanced countries will need monetary support, which implies low policy rates for years to come, while the monetary needs in the emerging and developing countries will be radically different. This will inevitably make fixed exchange-rate links crack under pressure as the same monetary policy cannot possibly be appropriate for both regions.

Finally, instead of managing common challenges, as in 2009, the G-20 members will need to manage their divergence. This will be a major test of resilience for an institution that demonstrated effectiveness in the crisis but still has to pass the test posed by this new phase in the global economy.
The Toronto summit will provide a first opportunity to assess the G-20’s ability to adapt to new conditions.