The Public Debts of the Developed Nations Could Well Lead to the Next Financial Crisis


(B) For the present academic year, some of the staff and faculty of the University of California at Berkeley, one of the most prestigious universities of the US, are on furlough to save $184 million to the State of California. The major opposition to the present health care bill, that aims to expand health care coverage to more than 90% of the US population, was its initial cost (although in its last form, estimated to cost $940 billion over 10 years, it shall reduce the US deficit to $138 billion). During Hurricane Katrina, 1,836 people lost their lives and the reconstruction costs of New Orleans, which is still unfinished, have run into the billions while it would have only cost $200 million to repair the levees. When a state or a nation (even the first economic power) runs a large budget deficit, it cannot even meet the most essential needs of its population such as education, health care, and safety. And, if a nation cannot address its most essential needs, it cannot prepare itself for a sustainable future!

A Brief History of Government Debts

One of the characteristics of emerging markets is the recurrence, sometimes even chronic, of their insolvencies such as debt crises in Latin America that spanned during the nineteen and twenty centuries. All European countries and the US at different stages of their economic developments from the Renaissance to World War II have gone through some recurrent external debt defaults just as many emerging markets do today. As a nation gradually transitions to a “matured” development stage, it usually builds a better ability to control its debt.  But let’s not fool ourselves, even in developed nations, highly leveraged economies with continual roll-over of new debts could very well lead to a new financial crisis. The collapse of the US Financial System in 2008 has reminded us that excessive debt accumulation can pose greater systemic risks than it seems during the booming years. And, excessive debt accumulation holds whether by governments, banks, corporations, or households is a serious risk to future economic prosperity. Debt lowers economic growth and lower economic growth makes the payment of the contracted debt much more challenging.

Nations facing excessive debts have two options:
to default, as it is a common case for emerging markets which requires the help of the International Monetary Funds (IMF) and or other nations to bail them out. Argentina holds the record for the largest default with $95 billion in 2001;
to issue more debt to pay back the present debt which is the case when a country has its debt in its own currency and can print new monies. But this leads to higher or even hyperinflation, higher interest rates, and government bonds with no values and negative returns for their investors.

The Present Debts of the Developed Nations

The current US Federal Government debt is estimated to be $14 trillion or close to 90% of its GDP! Around 53% of that debt is owned by Federal Government Accounts, 22% by domestic investors and, 25% by foreign investors. According to the US Treasury, the top five foreign owners of the US debt rank as follows:

First: China 24% or $895 billion
Second: Japan 21% or $766 billion
Third: Oil exporting countries (Saudi Arabia and other OPEC nations) 5.6% or $207 billion
Fourth: UK 4.8% or $178 billion
Fifth: Brazil 4.6% or $169 billion

The 2010 US federal budget deficit is estimated to reach $1.1 trillion or 10% of the US GDP on a budget of $3.5 trillion.

According to Professors Reinhart and Rogoff, authors of “This Time is Different: Eight Centuries of Financial Folly”, “a 90% ratio of government debt to GDP is a tipping point in economic growth. Beyond that, developed economies have growth rates two percentage points lower, on average, than economies that have not yet crossed the line. Or out of the G7, to the exception of Germany and Canada, all other countries have crossed or close to cross that line with the following ranking according to the IMF:

First: Japan 225% (2010 government debt to GDP)
Second: Italy 112%
Third: US 90%
Fourth: France 77%
Fifth: UK 69%

In more details, following are the current and projected fiscal deficits according to the IMF:

Nations with lower debts in the developing world are those with an economy-driven commodity such as Saudi Arabia or Chili or strong trading or manufacturing exporting economies such as Hong-Kong or China.

Present Challenges for the Developed Nations to Reimburse their Debts

The 2008 financial crisis has worsened the fiscal positions of most developed nations by first requiring them to support their financial systems, second by spending to stimulate their economies and last by lowering their taxes due to the economic recession. Nations that had already accumulated significant debts before the financial crisis are more at risk, in particular, the US, the UK, Japan, and some European countries.

What makes the problem worse for the US and other developed countries is first that the present recovery might not be strong enough to pay back enough of that debt quickly and second that spending is likely to increase to support an aging population.

As we all know, there are more people leaving the workforce than people entering it and people are living longer. This is not, however, a problem specific to the US but also largely spread in Japan and in Europe.

In the US, costs related to the three major entitlement programs, Social Security, Medicare, and Medicaid are growing faster than the economy can fund them. According to the Congressional Budget Office (CBO)  and the Treasury Department, those programs have a net present value of $40 trillion over the next 75 years!

The Pressure of the Sovereign Debts on Interest Rates

The US owns 45% of the total worldwide sovereign debt (sovereign debts are government bonds issued in a foreign currency). As a nation’s debt deteriorates, foreign investors sell their bonds, putting upward pressure on interest rates and causing the nation to devaluate its currency, which if the bonds are denominated in foreign currencies, makes it impossible for the country to pay back its debt.


That is what happened to Greece which has to be bailout with the help of other European countries and the IMF. But the UK, Spain, Portugal and Ireland, as did Greece, are facing more and more the pressure of their sovereign debt investors which as a consequence increases significantly the volatility of their credit default swaps (CDS) to protect against default of that debt (over the last few months, Greece CDS look like those of an emerging market – very expensive to buy!).

The pressure from investors on the US and Japan sovereign debt is less than for other developed nations but still very much a risk.

For the US, the dollar is still, fortunately, the world reserve currency and the US has the largest and most liquid debt market. But if China, Japan, Saudi Arabia, and other foreign investors lose their confidence in the US, not only will they reduce their willingness to invest further but they will ask higher interest rates.

For Japan, its debt is fortunately largely financed internally from its population savings but unfortunately, its population is shrinking!

The Urgent Need for the Developed Nations to Move Toward Fiscal Sustainability

In over a decade, the US has moved from a budget surplus of $559 billion under President Clinton to a budget deficit of $14 trillion under President Obama.

Between President Clinton and President Obama, the US has known two economic recessions, the first one due to the technology bubble and the second one due to the credit bubble. And the US has to finance increased Social Security and Medicare costs and a meaningless and frenetic war, like any other war!

Over the next few years, the US and the other developed nations (Japan, UK, France, Italy, Spain, Portugal, Ireland) need urgently to find the courage and the discipline to reduce and balance their debts. Let’s not believe, that among the developed nations, the bankruptcy of Iceland in 2008 and of Greece this year will be the last ones. The longer the developed nations are waiting to take the path toward fiscal sustainability, the more dramatic and the more limited will be their option ranging from fiscal austerity to structural reforms.

The US, for instance, must review and evolve its present entitlement programs, with Social Security and Medicare being first, and will have to combine in some way raising taxes (and maybe creating new ones) while lowering its spending, in particular, its defense budget.

While the US and the other developed nations are drafting new legislation to avoid another systemic risk from a highly-leveraged banking sector maybe they should be considering creating a new independent financial institution that will oversight the US and the other developed nations to avoid another type of systemic risk, this time due to their own public debts.

• US Treasury: Major Foreign Holders of Treasury Securities 
• US CIA: 2009 Country Public Debt as a Percentage of GDP
• Carmen Reinhart & Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton
• IMF, The State of Public Finance, March 6, 2009
• Nouriel Roubini, States of Risk, Project Syndicate, March 15, 2010
• Nouriel Roubini, The Risky Rich, Project Syndicate, January 18, 2010
• Nouriel Roubini and Arpitha Bykere, The Coming Sovereign Debt Crisis, Forbes Magazine, January 14, 2010
• Bill Gross, PIMCO, Investment Outlook, March 2010
• Bill Gross, PIMCO, Investment Outlook, April 2010
• Stephen Cecchetti, M S Mohanty, and Fabrizio Zampolli, The Future of Public Debt: Prospects and Implications, Bank for International Settlements (BIC)
• Wikipedia, United States Federal Budget (the two charts of this article are from this Wikipedia article)
• A Silicon Valley Insider, Too Big to Fail, June 28, 2009

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Categories: Economy, Financial Markets