CFR Analysis: The Sovereign Debt Dilemma

European countries' debt problems--in Greece, Portugal, Spain, Ireland, and elsewhere--have spurred market volatility and raised doubts about whether the global economic recovery is sustainable. Investors fled the euro after the European Union failed to convince them that faltering EU members could rein in government deficits and pay down debt. Investors are also questioning the U.S. dollar's stability--despite its rise against the euro--given the United States' growing deficits, high U.S. unemployment, and loose monetary policy.

While government interventions have led global recovery, the market's reaction to Greece and other indebted countries suggests governments may "have used up all their ammunition" to boost global growth, and their weakness causes a "new source of instability in the system," says Sebastian Mallaby, director of CFR's Center for Geoeconomic Studies and a senior fellow for international economics. Loss of confidence in sovereign debt means governments may have to continue fiscal and monetary stimulus, Mallaby says, though the markets will likely punish them for increasing budget deficits. Emerging markets continue to buy U.S. dollars "because they can't figure out where else to put their savings," he says, but once a viable alternative arises, "they will all jump." Mallaby says the United States is not at risk of inflation, since unemployment numbers remain high and industrial production low. That leaves room for the Federal Reserve to continue so-called "quantitative easing," or buying government securities to promote lending when interest rates are already near zero.
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