Busch: G20 Ignores Obama

Following the letter of Canada’s PM Stephen Harper, the G20 did something extraordinary: they’ve agreed to specific dates and amounts for fiscal deficit reduction.

“There is a risk that synchronized fiscal adjustment across several major economies could adversely impact the recovery. There is also a risk that the failure to implement consolidation where necessary would undermine confidence and hamper growth. Reflecting this balance, advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016.”

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G20 Summit

With the news, the equity markets are rallying with a risk on feel to it as they take comfort that the G20 has agreed to address their fiscal mess.

Clearly, the G20 nations realize the Greek experience is not one they want to repeat at home. It is a major victory for Canada and Germany as those countries have been advocating the ensemble embrace putting a fiscal plan in place.

While it may seem counterintuitive to some, the reasons for focusing on deficit reduction is spelled out in a paper by University of Chicago’s John H. Cochraneentitled, "Understanding Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic."

He comes to this startling conclusion:

“Will we get inflation? The scenario leading to inflation starts with poor growth, possibly
reinforced by to larger government distortions, higher tax rates, and policy uncertainty. Lower growth is the single most important negative influence on the Federal budget. Then, the government may have to make good on its many credit guarantees. A wave of sovereign (Greece), semi-sovreign (California) and private (pension funds, mortgages) bailouts may pave the way. A failure to resolve entitlement programs that everyone sees lead to unsustainable deficits will not help.”

“When investors see that path coming, they will quite suddenly try to sell government debt and dollar-denominated debt. We will see a rise in interest rates, reflecting expected inflation and a higher risk premium for U.S. government debt. The higher risk premium will exacerbate the inflationary decline in demand for U.S. debt. A substantial inflation will follow — and likely a “stagflation” not inflation associated with a boom. The interest rate rise and inflation can come long before the worst of the deficits and any monetization materialize. As with all forward-looking economics, no obvious piece of news will trigger these events. Officials may rail at “markets” and “speculators.” Economists and the Fed may scratch their heads at the sudden “loss of anchoring” or “Phillips curve shift.”

Clearly, the G20 has this scenario in mind along with the Greek experience and has attempted to lay the groundwork for nations to reduce their deficits. It is the best news I’ve seen for reducing uncertainty since the European sovereign debt crisis began last November.

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Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.