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Dangerous debt

August 12, 2011

As Europe's debt crisis continues to spread, leaders are scrambling to calm markets. Debt levels in many nations have been growing for years, and economists say tough action is needed to get them down.

stacks of euro bills
Government debt in many countries is a serious threatImage: picture-alliance/dpa

For years, finance markets have watched uneasily as government debt has built up around the world. According to an analysis by the International Monetary Fund, global debt has increased by a factor of four since 1990, reaching $95 trillion (66 trillion euros) today.

The debt level in the United States was $49 billion in 1940; today it is $14.3 trillion. In the wake of the controversial debt-ceiling deal forged amid much rancor at the beginning of August, another $2.1 trillion will be added to that amount in the coming months.

Even Germany, considered by many to be a model of fiscal prudence, has seen its government debt rise substantially over recent decades. While debt made up 15 percent of GDP at the end of World War Two, today it stands at close to 80 percent.

Euro and EU star logo
Europe's debt crisis is putting the future of the euro in doubtImage: picture alliance/ZB

The relationship between debt and an economy's economic output, or gross domestic product (GDP), is a measuring stick for the financial markets. Even if debt levels are relatively high or growing, if economic performance is relatively robust, there is little need to worry about possible default and markets in the past haven't been much concerned.

But economic performance has not been able to keep up with growing debt levels recently, especially due to the severe global economic recession of 2008. Now the debt-to-GDP ratio is making investors uncomfortable.

The huge debt problems faced by European countries like Greece, Spain, Italy and now France, the downgrading of the United States' credit rating by Standard and Poor's, and fears in late July that the US might default on its debts due to political gridlock have helped to send stock markets around the world into a tailspin. Real fears have surfaced about a second serious recession and there are doubts over long-term prospects for economic growth.

"Markets are signaling that the imbalances have become too big," Ulrich Kater, chief economist at Dekabank, told Deutsche Welle.

Living too large

Several industrialized countries - especially the United States, Spain and Great Britain - have simply lived beyond their means. Governments spent heavily in the wake of the global economic crisis on stimulus programs or bank bailouts during a period of negative growth and stock market downturns so they could avoid an even grimmer situation.

But as those moves pushed debt levels up, economic growth rates stayed stagnant or weak, which worsened the debt-to-GDP ratio even more.

Standard and Poor's office
The downgrade by Standard & Poor's of America's credit score unnerved investorsImage: picture-alliance/dpa

In addition, politicians seeking favor with voters have long brought home the bacon from state or federal capitals and avoided making the painful decisions necessary to reform an ailing system and get the financial house in order.

Today, markets and even many of those voters who once welcomed lawmakers' largesse have lost faith in the stability of the financial system and the ability of the government to pay back what it owes.

Now it is time to pay the piper, experts say, and it is not possible simply to write off the mountains of debt that have accumulated or put off their repayment until some future date. Countries which have lived above their means, said Norbert Walter, former chief economist at Deutsche Bank, have to return to the straight and narrow.

"We have to see a correction take place with private individuals who have spent too much as well as with governments who have also spent too much," he told Deutsche Welle. "It will be painful since it will curb growth, feel like a recession and last a long time."

Austerity the answer?

These days many countries are, by choice or under pressure from others, launching austerity programs to bring their debt levels down.

Britain's conservative-liberal democrat coalition government, which took office last year, has sought to axe public spending and hike taxes in order to slash its own record deficit and preserve the nation's top-level AAA credit rating.

trader and DAX screen
Markets have been roiling as investors remain skittish about the state of the world economyImage: dapd

"We must continue to put our own house in order," Chancellor of the Exchequer George Osborne told the country's parliament, warning that economic recovery "will take longer and be harder than had been hoped."

That approach has gained credibility with many governments these days, including Germany's to some extent. Many are less enamored of stimulus spending now than they were in the darkest days of the economic crisis.

"If governments return to the 'path of virtue,' the economy and citizens might well regain some of the trust they have lost," according to Stefan Schneider, an economist with Deutsche Bank.

But it will be a delicate situation, added Dekabank's Kater, and governments will have to pull off a tricky balancing act. They have to be careful not to cripple the economy by instituting austerity measures that are too severe. But on the other hand, large-scale savings are essential.

"This is the dilemma," Kater said. "Financial markets demand quicker action than is possible by the mechanisms governments realistically have at their disposal."

States are left with few options other than trying to win back credibility and calming financial markets by laying out how they will improve the debt-to-GDP ratio in the future. But that is not something that can be done in one or two years, Kater added, rather, it is a project that can take decades. Meanwhile, turmoil continues to plague the markets.

Debt and growth

It is accepted among almost all economists that some government debt, at times, is a good thing. For example, in a recession, tax revenues fall, and you need more money for social programs such as unemployment insurance, so the government should go into deficit.

But how much is too much? An IMF report looking at 15 emerging markets found that a median debt level of 30 percent was sustainable. But in general, developed nations can sustain higher debt levels than emerging ones, and industrial countries on overage had public debt levels above 70 percent of GDP for most of the 1990s.

dollar bills
US government debt has reached levels not seen since just after World War TwoImage: picture alliance/dpa

An influential 2009 book by economists Carmen Reinhart and Kenneth Rogoff, called "This Time is Different: Eight Centuries of Financial Folly," and a separate report entitled "Growth in the time of debt" looked economic data and financial crises across dozens of countries and hundreds of years.

The researchers claimed there is no association between debt and growth at low or moderate levels of debt, but they said there is a well-defined threshold - around 90 percent in their estimation - of government debt relative to GDP above which economic growth is hindered.

If debt levels reach 100 percent, according to experts, a nation's economy can easily be derailed by, say, an interest rate increase or an economic slowdown.

In early August, US debt shot up $238 billion to reach 100 percent of GDP after the Washington raised the debt ceiling. It was the first time since 1947 that debt topped the size of America's annual economy. In 1981, debt was down to 32.5 percent.

According to a ranking by the EU statistics agency Eurostat, Japan is the world's most indebted country, with debt totalling 226 percent of GDP. Further down on the list are Greece, at 144 percent, and Italy, at 118 percent.

The EU's Maastricht Treaty, signed back in 1992, set limits to countries' debt-to-GDP ratio at 60 percent. The rules have not be adhered to.


Many observers say debt reduction must be one of the highest priorities of governments. Financial policy must orient itself toward financial responsibility and governments have to take a clear-eyed look at what it can afford. Fiscal conservatives, especially in the US, want to see balanced budgets mandated by law. Others say some debt is fine, but not at current levels.

But getting the budget in line is a task that involves long-term thinking, something that many of today's politicians and voters have little patience for. The situation is made all the more difficult by demographic developments in many parts of the industrialized world. Populations are shrinking, which leads to a reduction in tax revenues.

Experts warn that the world is facing a difficult period. Some compare it to the experience of the drug user that has to go through an ugly withdrawal phase in order to get free of his addiction. In the globe's case, it's about beating a long-held dependence on debt. The financial markets are demanding that countries get clean, or else.

Author: Brigitte Scholtes / Kyle James

Editor: Sean Sinico